On 12 September the European Commission unveiled its proposals for the transfer of supervisory responsibilities to a European level to the ECB. This is the first step towards a banking union, with the transfer of deposit insurance and resolution at a European level being the other two. This column reviews the main advantages of moving supervision to a European level and to the ECB in particular and highlights some of the resulting challenges and risks, also in relation to the other two steps as the three functions – supervision, deposit insurance, and resolution – are intimately interconnected.

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The European Commission’s proposal in brief

The European Commission’s proposal suggests that all banks in the Eurozone are subject to prudential supervision by the ECB as of January 2014 (European Commission 2012a). The supervision of large and systemically important banks and banks that are under government support should be phased in a year earlier; although this seems to be overly optimistic on the speed with which agreement on ‘fine tuning’ the proposal can be reached. EU countries that have not adopted the euro can choose to be supervised by the ECB on a voluntary basis. In a separate proposal (EC2012b), the Commission also suggests that the European Banking Authority (EBA) should not only remain in charge of creating a single ‘rulebook’, but that is also tasked with the creation of uniform supervisory practices – a single ‘supervisory handbook’ – to ensure that uniform rules and enforcement apply for all EU banks as to create and maintain a level playing field.

As it stands currently, the Commission’s proposal gives sweeping powers to the ECB for all aspects of bank supervision as well as some crisis management powers. Within the Eurozone, the ECB will be responsible for licensing credit institutions, ongoing bank supervision to ensure compliance with safety and soundness, early intervention in troubled institutions with powers to require corrective measures such as capital and liquidity injections, and improvements in corporate governance. The ECB will also have the power, “in cooperation with the relevant resolution authorities”, to close down an institution if necessary. Currently the resolution of failed institutions rests with national authorities. As part of the banking union, this task is expected to move to a European level to increase the speed with which failed institutions are wound up, internalise externalities that arise in the case of cross-border institutions, and reduce regulatory capture. The identity, structure, and the exact division of tasks between the ECB and the resolution authority are still to be delineated, but one thing is known for sure: this decision will have important implications for the ultimate success of this first step. The way institutions die determines how they live! Beyond any corrective behavior that any policeman can hope to achieve, the way the courts will handle the case is likely to have a first order effect in creating the right incentives ex ante.

What does moving supervision to a European level buy? And what does it cost?

Moving supervision to a European level does not necessarily imply that supervision should be moved to the ECB. That is a separate issue – one that is addressed below. Before turning to that, however, it is important to understand what moving supervision to a European level buys and what it costs.

Having a single European supervisor should increase the likelihood that the rules and enforcement that govern the regulation and supervision of banks would be more uniform across the various EU or Eurozone countries, creating a level playing field in an integrated financial market, ensuring minimum standards, and reducing risk-shifting opportunities abroad (see, for example, Ongena et al, forthcoming). Uniform rules and enforcement is also a minimum prerequisite for deposit insurance and resolution to be moved to a European level without causing social and political upheaval as both will be pre-funded by bank and state contributions from all participating countries. Moving supervision to a European level will also increase the distance of supervisors from powerful national lobbies, reducing the scope for regulatory forbearance. As the financial crisis highlighted, there is a tendency by national supervisors to side with their troubled banks in hiding information from the public and other supervisors, delaying the recognition of losses, postponing corrective measures, and resulting in larger eventual losses. The lack of sufficient independence of some national supervisors from the executive (in combination with insufficient and explicit powers to intervene) magnifies this problem. This problem is also at the heart of the current vicious cycle between bank and sovereign risk. Finally, having a single European supervisor will help improve the oversight of cross-border institutions and perhaps more importantly, also allow for an earlier detection of systemic risk at the level of the EU as a whole.

But what are the costs? Creating a new pan-European supervisor ‘from scratch’ is a daunting task and a very expensive one too, especially given the EU’s current state of fiscal finances. The infrastructure that needs to be put in place and the highly skilled employees that will need to be hired in such a short period of time should not be taken lightly. (Talent and skills are scarce, especially when the other side of the camp pays multiple times more.) And what are we supposed to do with the current infrastructure and employees at the national competent authorities (some of whom have ‘jobs for life’)? Moving supervision at the European level does not require that we ‘reinvent the wheel’. The new European supervisor could rely on the national supervisors for the day-to-day supervision, especially for the smaller and less systemically important institutions where a deep knowledge of the local economies may be important. The European supervisor will obviously need to oversee the national supervisors in a clear hierarchical structure and possibly have an examiner regularly present at the national supervisors. (A rotation system as in the US would not work well as it will give rise to coordination and informational problems (see Agarwal et al. 2012). Working closely with national authorities in an integrated system would avoid unnecessary centralisation of powers, duplication of structures, and the loss of knowledge on the local economies. As it stands currently, the Commission’s proposal suggests that the ECB – the European institution put in charge of supervision – should “acquire competences” in carrying out the task and build up a new administrative structure for its fully centralised exercise.

But why the ECB? Why not?

As mentioned above, moving microprudential bank regulation and supervision at a European level does not necessarily imply moving it to the ECB. Why the ECB? As very succinctly put by Charles Wyplosz in a recent opinion piece borrowing from Bagehot (1873): every banking system needs a lender of last resort and a central bank is the only institution that can fulfill this role given the large amount of money that needs to be mobilised in a very short period of time, especially in the new interconnected world that we live in today (Wyplosz, 2012). For a central bank, however, to be able to act appropriately it must have intimate knowledge of the exact situation of the banks for which it is supposed to act as a lender of last resort in real time, which requires supervisory responsibilities. The underlying assumption here is that the channeling of accurate and unbiased information from other institutions that do not necessarily share the same incentives cannot be trusted, especially when there is no time or sufficient information to gather an own opinion. Under this argument the ECB – the Eurozone’s ultimate central bank and lender of last resort – should have the responsibility of supervising the Eurozone’s banks as it is ultimately responsible for maintaining the stability of the financial system and of the euro itself. As Wyplosz (2012) points out, this logic was deliberately ignored when the single currency was created, giving in to pressures from both banks and national supervisors. The Commissions’s proposal essentially aims at correcting this ‘birth defect’.

The lender of last resort argument does not apply to EU countries that are not in the Eurozone. These countries have their own currencies and their own central banks who can assume the responsibilities of the lender of last resort. In fact, the Commission’s proposal does not transfer the supervision of non-Eurozone banks to the ECB, but allows them to join on a voluntary basis1. (Anything shorter than that, would have guaranteed that the EC’s proposal will be vetoed by opposing countries.) As a result, some of the advantages of moving supervision to a European level – mentioned above – will fall short of reaching their full potential. For example, while the supervision of cross-border institutions will be on a consolidated basis for their Eurozone activities, there will still be need for co-ordination between euro and non-euro jurisdictions. Similar examples can be made for the other advantages mentioned above – although the problems with the uniform rules and their enforcement may be mitigated by the EBA’s common ‘rulebook’ and ‘handbook’ that will apply to all EU countries, not just those in the Eurozone.

One important concern of hosting monetary policy and bank supervision under the same institution has to do with the potentially conflicting goals of the two tasks (see, for example, Goodhart and Schoenmaker 1992). Monetary policy is usually countercyclical, while the effects of regulation and supervision tend to be procyclical, offsetting to some extent the objectives of monetary policy. In particular, during periods of economic slowdown, the financial condition of banks deteriorates and supervisors step in and apply pressure on the institutions to improve their condition. However, the implementation of these requirements will typically result in tighter credit, reinforcing the recession2. Following this line of argument, one might expect that a central bank may ‘go easier’ on supervision to support monetary policy objectives. Supervision could also influence the conduct of monetary policy. It is often argued that interest rates may be kept lower than otherwise because of concerns about the banking sector, resulting in worse performance with respect to price stability3. Because of such conflicts, it is often argued that monetary policy and bank supervision should be kept separate, and when hosted under the same institution, ‘Chinese walls’ should be erected between the two functions. The EC’s proposal seems to share these concerns as it proposes a segregation of activities between monetary policy and bank supervision within the ECB. Carmassi et al (2012) argue that separation seems hardly guaranteed under the proposed set-up as supervision will be under the “oversight and responsibility” of the ECB’s governing council – they argue instead that setting-up of a separate and independent governing council within the ECB would be a better alternative.

Giving supervisory responsibilities to a central bank could also have some important positive effects. Peek et al. (1999) argued that information obtained from bank supervision could improve the accuracy of economic forecasting, and thus help the central bank to conduct monetary policy more effectively. Problems in the banking sector may serve as an early indicator of deteriorating macroeconomic conditions4. Using data from the US – where the Fed is responsible for monetary policy and the supervision of some of the largest US banks – the authors showed that supervisory information can and does help the Fed to conduct monetary policy more effectively. They found that confidential information on the health of the banking system (CAMEL ratings) is useful in predicting inflation and unemployment, but is not used by private forecasters or by the Fed itself in its forecasts. Although, the Fed does not seem to make systematic use of this information in its Greenbook forecasts, Peek et al. found that this confidential information is taken into account when setting monetary policy (i.e., it is found to affect the votes of the FOMC members). While they showed the FED’s supervisory responsibilities affect its contact of monetary policy, Ioannidou (2005) showed that monetary policy also affects the Fed’s behavior as a bank supervisor: when the Fed tightens monetary policy, it becomes less strict in bank supervision (i.e., an increase in interest rates or a decrease in reserves is associated with a lower probability of intervention). Monetary policy instead is not found to alter the behavior of the other two federal supervisors – the FDIC and OCC – who do not have monetary policy responsibilities. One possible explanation for these finding is that the Fed is less strict on supervision to compensate banks for the extra pressure it puts on them when it tightens monetary policy, either because it is concerned about possible adverse effects from bank failures on its reputation or because it is concerned about possible adverse effects on financial stability. After all the Fed is responsible for maintaining the stability of the financial system and it supervising of some of the largest banks in the US.

Although I do believe that combining the two functions under the same institution will result in cross-effects from one function to the other – existing evidence from the US that is reviewed above supports this belief – the discussion about conflicts of interests is a somewhat artificial. The ‘conflicts’ described above are genuine and are not likely to be eliminated by institutional rearrangements. Giving up one objective in favour of another will sometimes be unavoidable at the Society’s level. Eliminating the problem at the level of a particular institution is not going to solve these conflicts. An important question is which institutional setup would resolve these conflicts in the most efficient way for the society at large. One could argue that internalising conflicting goals within a single institution may result in a more efficient resolution because of lower frictions in deciding and implementing policies and because of enhanced accountability. It may also allow the central bank to internalise and react to unintended consequences that monetary policy may have on banks risk-taking incentives (see Ioannidou et al. 2009 and Jiménez et al. 2009). On the other hand, supervisory failures, which to some extent are unavoidable, might undermine the ECB’s reputation and credibility in preserving price stability (especially if banks view this integrated approach as access to a larger ‘put option’). If a central bank is responsible for bank supervision and bank failures occur, the public perception of its credibility could be adversely affected (e.g., Bank of England and the failure of BCCI in 1991). It is therefore very important that the banking union is completed. Improving the end-game is of crucial importance for setting the right incentives ex ante and giving the ECB a chance (to succeed).

European Commission (2012a), Council Regulation conferring specific tasks on the European Central Bank concerning policies relating to the prudential supervision of credit institutions.

European Commission (2012b), Regulation of the European Parliament and of the Council amending Regulation (EU) No 1093/2010 establishing a European Supervisory Authority (European Banking Authority) as regards its interaction with Council Regulation (EU) No…/… conferring specific tasks on the European Central Bank concerning policies relating to the prudential supervision of credit institutions.

1 This choice should be made at the country level (and not at the level of an institution). Opting in and out easily should not be possible, as this will induce strategic behavior and a ‘race to the bottom’.

2 The slow recovery from the 1990 U.S. recession was attributed by many researchers to a dramatic decrease in the supply of bank loans caused by increased capital requirements and more stringent regulatory practices (Bernanke and Lown, 1991; Berger and Udell, 1994; Berger, Kashyap and Scalise, 1995; Hancock, Laing and Wilcox, 1995).

3 During the 1980s and the beginning of the 1990s, the US interest rates were kept low because of the severe problems of the Savings and Loan Associations (Vittas, 1992). Central banks with supervisory responsibilities have been found to have worse track records in fighting inflation (Goodhart and Schoenmaker (1992). This is true even after controlling for central bank independence (see Di Noia and Di Giorgio, 1999).

4 To the extent that the ‘lending channel’ of monetary policy is operative, supervisory information could provide advance notice of changes in bank lending behavior (see, for example, Bernanke and Gertler, 1995; Hubbard, 1995; and Kashyap, Stein and Wilcox, 1993).